Dimon Says Overconfidence Fueled Loss He Can’t Defend

JPMorgan Chase & Co. (JPM) Chief Executive
Officer Jamie Dimon said overconfidence in trusted managers
allowed traders to accumulate more than $2 billion in losses
through a strategy that “violated common sense.”

Risk-monitoring systems and executives at the largest U.S.
bank failed to adequately police threats concentrated in a
derivatives portfolio at a London unit of the chief investment
office, he said. The division wasn’t subjected to the same
scrutiny as other businesses, and managers there deviated from
control procedures, even after triggers on risk limits were
breached, Dimon told the Senate Banking Committee yesterday.

“The first error we made was that the CIO unit had done so
well for so long that I think it was a little bit of complacency
about what was taking place,” Dimon, 56, said. The CIO made
“several billion dollars” in the three or four years preceding
the loss on a book of credit derivatives designed to profit if
the U.S. economy weakened and corporations were under duress.
“It changed into something I cannot publicly defend,” he said.

Under pressure from lawmakers after disclosing the loss on
May 10, JPMorgan may test pay provisions to reclaim bonuses and
stock compensation from executives. The loss has renewed debate
in Washington for tighter trading curbs and raised questions
about whether anyone can manage a financial empire as vast as
JPMorgan, which has more than $2.3 trillion in assets, larger
than the annual gross domestic product of Brazil or the U.K.

“You’re obviously renowned, rightfully so,” for being one
of the best CEOs in the industry, said Senator Bob Corker, a
Tennessee Republican, in a two-hour hearing. “But are these
institutions today just too complex to manage?”

London Cowboys

The hearing left some senators with unanswered questions
about exactly what went wrong at the New York-based bank.
Democrats including Senator Jeff Merkley of Oregon said the loss
shows the need for the Volcker rule, which limits so-called
proprietary trading where banks bet their own funds to make a
profit, rather than hedge operational risks, as Dimon said the
trades were intended.

“I don’t want to see consumer lenders in Columbus losing
their jobs because cowboys in London make too many risky bets,”
said Senator Sherrod Brown, an Ohio Democrat, referring to
19,000 JPMorgan employees in his state.

JPMorgan is down 16 percent in New York trading since the
May 10 disclosure, erasing about $24.5 billion in market value.
The stock rose 1.6 percent to $34.30 yesterday.

“He exceeded my expectations and he kept his cool,” Bruce Foerster, president of South Beach Capital Markets in Miami,
said of Dimon’s testimony. “He looked like a confident leader
willing to show humility.”

‘Solidly Profitable’

While Dimon wouldn’t update the size of the loss on the
derivatives book, which he had previously said could widen by $1
billion or more, he forecast the bank would be “solidly
profitable” when it reports second-quarter results on July 13.

“One of the big issues is we didn’t know what the
potential loss will be, but he just put a circle around it,”
said Marty Mosby, a Memphis, Tennessee-based analyst at
Guggenheim Securities LLC, who assigns a “buy” rating to the
shares. “You have to start clawing your way up the mountain and
this was the first step in the right direction.”

Dimon said he called Chief Investment Officer Ina Drew and
spoke with the company’s risk officers as well as Chief
Financial Officer Doug Braunstein before the company reported
earnings on April 13, the day the CEO called news reports about
the trades a “tempest in a teapot.”

“I was assured by them, and I have the right to rely on
them, that they thought this was an isolated, small issue,”
Dimon said. Drew retired May 14 and Achilles Macris was stripped
of his operational duties heading the CIO in Europe and Asia.

‘Complex Strategy’

The bank instructed the CIO in December to reduce its risk-
weighted assets to prepare for new international capital rules,
Dimon said. Instead, the office in mid-January “embarked on a
complex strategy that entailed adding positions that it believed
would offset the existing ones,” he said.

The bank asked traders in March to scale back after limits
around credit risk and exposure were breached, Dimon said.

“What should happen afterwards is people focus on it,
think about it and decide what to do,” Dimon said. The risk
committee in the unit wasn’t independent enough and should have
more rigorously policed the credit derivatives book, he said.

Dimon said a new formula for estimating possible trading
losses, which was implemented in mid-January, may have
exacerbated the problem. JPMorgan uses a value-at-risk
calculation to estimate the maximum amount that traders would
expect to lose on 95 out of 100 trading days, according to
quarterly filings with regulators. It’s calculated daily, and
the average for a quarter is reported in regulatory filings.

‘Still Unaware’

“We were still unaware that the model might have
contributed to the problem” as of April 13, he said.

The switch, and the timing of the firm’s disclosures, are
the focus of an inquiry by the Securities and Exchange
Commission as the government examines how long senior executives
knew about the CIO’s swelling bets and losses. Dimon said May 10
that the bank had reviewed the effectiveness of the new VaR
model, deemed it “inadequate” and decided to return to the
previous version, which almost doubled the unit’s risk estimate.

The bank hasn’t yet found any “nefarious purposes”
behind the change, which was reviewed for six months beforehand,
he said. The chief investment office asked to switch the VaR
model “sometime in 2011,” Dimon said during the hearing. An
independent group reviewed the proposed change and the new
formula had “back-tested better” than the old one, he said.

He was copied on a memo approving the change, Dimon said
afterward in an interview with CNBC, according to a transcript.
“I paid virtually no attention to it. I didn’t think it was
significant,” he said.

‘Bad Judgment’

The board of directors may use so-called clawback
provisions in executive compensation plans to reclaim pay made
in the past two years, he said. Dimon’s $23 million pay package
for 2011 made him the highest-paid U.S. banker and Drew was paid
$14 million for her work last year.

“For senior people, which most of these people are, you
can claw back for even bad judgment,” Dimon told the committee.
“When the board finishes its review, which is the appropriate
time to make those decisions, you can expect that we will take
proper corrective action and it is likely there will be
clawbacks.”

It was the first of two appearances Dimon will make on
Capitol Hill to face lawmakers probing how the most profitable
U.S. bank, often praised for its “fortress” balance sheet,
could have taken such risks after coming through the 2008
financial crisis without a single quarterly loss. Dimon
testifies again on June 19 before the House Financial Services
Committee.

Shelby, Menendez

“What we don’t know yet, we don’t know the details of what
kind of position they took, what they were doing,” said Richard Shelby of Alabama, the senior Republican on the committee, after
the hearing. “We’ll find that out in due time and we’ll be able
to tell if they were managing risk or just seeking profits.”

Five U.S. agencies are working to complete the Volcker
rule, which is named for former Federal Reserve Chairman Paul Volcker and is intended to reduce risky trading by banks with
federally insured deposits and access to the central bank’s
discount window.

Senator Robert Menendez, a New Jersey Democrat, pressed
Dimon on whether the bank was hedging its credit risk or
gambling for profit, saying that the loss stemmed from the same
types of securities that were at the heart of the 2008 financial
crisis, synthetic credit-default swaps. “This transaction that
you said morphed, what did it morph into? Russian roulette?” he
asked.